Corporate finance exam
PV of a zero-coupon bond:
→ P = FV/(1+r)^t
r = risk free rate
t = duration
CAPM: it defines the exp.return we use in the pv calculation
Capital structure and leverage
Firms can be financed in two different ways:
(i) Debt financing
(ii) Equity financing
Differences:
Maximum payout/loss
Debt is senior to equity
Modigliani & Miller : No differences between the expected returns between different
capital structure in the Perfect Capital Market
Perfect capital market
Assumptions
- No transaction costs, no taxes and no issuance costs
- A firm’s financing decision does not change the CFs generated by its
investments
- Investors and firms can trade the same set of securities at competitive makret
prices equal to the present value of their future cash flows.
→ If these conditions are respected, the 1st proposition of M&M is
true
Leverage does not affect the total value of the firm
M&M II
From the 1st proposition of M&M, we derive that:
E+D=U=A
From the above equation, we can derive that:
Ru = unlevered return
→ if we solve for Re:
From analyzing this formula, we get to the II proposition of M&M:
,The cost of capital of levered equity increases with the firm’s market value debt-
equity ratio.
Same, but now with betas
Interest tax shield
Firms pay taxes on the profits they earn
Profit = earnings - operating costs - … - interest payments
Therefore, if you face interest payments, you will have lower profits
Consequently, lower amount of taxes
But if the net income is lower with leverage, why should I take a debt?
Interest tax shield represents the amount of money a firm would have paid if it did
not have leverage.
Value of the levered firm
Cash flows of the levered firm are equal to the sum of the cash flows from the
unlevered firm plus interest tax shield.
Vl = Vu + interest tax shield
After tax WACC
Personal taxes
To determine the true tax benefit of leverage, we need to evaluate the combined
effect of both corporate and personal taxes
Effective tax advantage of debt
Personal taxes reduce the tax advantage of debt
Consequently, how much is the new tax advantage?
, Distress and default
Financial distress: when a firm has difficulty in meeting its debt obligations
Default: when a firm fails to make the promised payments on its debt
Which are the promised payments?
1. Interest payments on debt
2. Principal payments on debt
4 scenarios
There is not a direct disadvantage to debt financing, the risk of bankruptcy is not a
disadvantage of debt; bankruptcy only shifts control from shareholders to creditors.
Bankruptcy process
Bankruptcy is often a long and complicated process that imposes both direct and
indirect financial costs on the firm and its investors.
Two ways of dealing with bankruptcy:
Liquidation:
- All companies assets are sold
- The proceeds are used for paying back creditors
- The firm ceases to exist
Reorganization:
- Usually only for large corporations
- It is given the opportunity to propose a reorganization plan
Trade off theory
What do we know so far:
- We can finance the firm by equity or debt
- Existence of tax shield suggests us to use debt financing
- But, too much debt will increase the probability of financial distress, even
before not being able to repay our creditors (bankruptcy)
PV of a zero-coupon bond:
→ P = FV/(1+r)^t
r = risk free rate
t = duration
CAPM: it defines the exp.return we use in the pv calculation
Capital structure and leverage
Firms can be financed in two different ways:
(i) Debt financing
(ii) Equity financing
Differences:
Maximum payout/loss
Debt is senior to equity
Modigliani & Miller : No differences between the expected returns between different
capital structure in the Perfect Capital Market
Perfect capital market
Assumptions
- No transaction costs, no taxes and no issuance costs
- A firm’s financing decision does not change the CFs generated by its
investments
- Investors and firms can trade the same set of securities at competitive makret
prices equal to the present value of their future cash flows.
→ If these conditions are respected, the 1st proposition of M&M is
true
Leverage does not affect the total value of the firm
M&M II
From the 1st proposition of M&M, we derive that:
E+D=U=A
From the above equation, we can derive that:
Ru = unlevered return
→ if we solve for Re:
From analyzing this formula, we get to the II proposition of M&M:
,The cost of capital of levered equity increases with the firm’s market value debt-
equity ratio.
Same, but now with betas
Interest tax shield
Firms pay taxes on the profits they earn
Profit = earnings - operating costs - … - interest payments
Therefore, if you face interest payments, you will have lower profits
Consequently, lower amount of taxes
But if the net income is lower with leverage, why should I take a debt?
Interest tax shield represents the amount of money a firm would have paid if it did
not have leverage.
Value of the levered firm
Cash flows of the levered firm are equal to the sum of the cash flows from the
unlevered firm plus interest tax shield.
Vl = Vu + interest tax shield
After tax WACC
Personal taxes
To determine the true tax benefit of leverage, we need to evaluate the combined
effect of both corporate and personal taxes
Effective tax advantage of debt
Personal taxes reduce the tax advantage of debt
Consequently, how much is the new tax advantage?
, Distress and default
Financial distress: when a firm has difficulty in meeting its debt obligations
Default: when a firm fails to make the promised payments on its debt
Which are the promised payments?
1. Interest payments on debt
2. Principal payments on debt
4 scenarios
There is not a direct disadvantage to debt financing, the risk of bankruptcy is not a
disadvantage of debt; bankruptcy only shifts control from shareholders to creditors.
Bankruptcy process
Bankruptcy is often a long and complicated process that imposes both direct and
indirect financial costs on the firm and its investors.
Two ways of dealing with bankruptcy:
Liquidation:
- All companies assets are sold
- The proceeds are used for paying back creditors
- The firm ceases to exist
Reorganization:
- Usually only for large corporations
- It is given the opportunity to propose a reorganization plan
Trade off theory
What do we know so far:
- We can finance the firm by equity or debt
- Existence of tax shield suggests us to use debt financing
- But, too much debt will increase the probability of financial distress, even
before not being able to repay our creditors (bankruptcy)
